Report on Marks and Spencer - Essay Example

Financial Management Report on Marks and Spencer Introduction Marks and Spencer operates in the hi-end niche market of the retailing business. The company operates in a number of countries worldwide. Financing at Marks and Spencer Marks and Spencer is funded by Equity in the amount of ?2,185..9 million and non-current liabilities of ?3,076.6 million. On April 3, 2010 Marks and Spencer was financed by Total liabilities of ? 4,967.3 million consisting of current liabilities (due within the next 12 months) of ?1,890.5 million and non-current liabilities of 3,076.6 million. The current liabilities includes trade payables and other payables, borrowings and other financial liabilities, partnership liability to the pension scheme, derivative financial instruments, provisions and current tax liabilities. The company had Interest bearing debts from external sources of ?2,760.9 million and loans from partners to fund the pension scheme of ?71.9 million. Both consist of a mix of a long term portion and a short term portion which is due within the next 12 months. The table below provides that information for interest bearing or fixed interest debt.. Interest Bearing Debts Period Partnership loans ? Other Interest Bearing Loans ? Total Current 0 482.9 482.9 Non-current 71.9 2,278.0 2349.9 Total 71.9 2,760.9 2832.8 Marks and Spencer’s Financial Structure The following ratios in the table below will assist in the assessment of Marks and Spencer. Ratio Formulae 2010 2009 Debt Management Debt ratio (Total liabilities/Total assets) x 100% (4,967.3/7,153.2)x100% = 69.4% (5,157.5/7,258.1) x 100 = 71% Gearing Ratio Interest Bearing Debts (IBD)/Equity + IBD 2,832.8/5,018.7 = 56.4% 3,200.6/5,301.2 = 60.38% Interest Cover Profit Before Interest and Tax (PBIT)/Interest Expense 852/162.2 = 5 times 870.7/214.5 = 4 times Liquidity Ratio Current ratio Current assets/current liabilities 0.80 0.60 Acid Test Ratio Current assets - inventory)/current liabilities 0.47 0.37 Debt Management The debt management ratios indicate how the company’s management has managed the debts of the company. According to Brigham (2005) the extent to which debt financing, which is also referred to as financial leverage is used by a firm has three implications. Firstly, financing the business using debt will allow share holders to maintain control of the company without increasing their investment in it. Secondly, shareholders returns can be substantially increased if the company earns more on investments that are financed with borrowed funds. However, financial risk increases as debt increases. Thirdly, creditors depend on shareholders to provide a margin of safety. Therefore the more funds supplied by shareholders the more comfortable they are in doing business with the company. Additionally, the interest expense which relates to interest charged on borrowed funds is allowable as a deduction for tax purposes. Dividend is not so allowed and is a distribution after tax is deducted. The Debt Ratio The debt ratio is the ratio of total liabilities to total assets and provides information on how much of the funds are provided by sources other than equity. The company’s debt ratio is 69.4% for the year ended April 3, 2010. Although this is an improvement over the previous year’s figure of 71%,. the guideline indicates that a percentage over 50% percent does not augur well. Marks and Spencer’s debt ratio is unfavourable and indicate problems with its financial structure. However, a comparison with the average in the industry in which Marks and Spencer operates is important. The gearing ratio below will provide additional information. The Gearing Ratio The gearing ratio is the portion of interest bearing debts to equity and interest bearing debt. The gearing ratio of 56% suggests that the company has a significant amount of interest bearing debt in its capital structure. The normal threshold of 50% has been exceeded. However, whether the ratio is favourable or not depends on the industry. The ratio for the year ended April 3, 2009 was 60%, which indicates that there was a reduction in 2010. However, this figure still does not put the company in a favourable position. There is room for improvement and Marks and Spencer has to find ways to improve this ratio. If the ratio is not improved it will have implications for interest rates that the company. The company’s ability to obtain loans at competitive interest rates will be hindered.. Interest Cover The interest cover indicates whether or not the company is able to service its debts. It provides information on the amount of times that fixed interest charges are covered by operating income before interest and tax. BPP (2009) indicates that a minimum of 3 times provide a good coverage. The ratio has improved from 4 times in 2009 to 5 times in 2010. Liquidity Ratios – current and acid test ratios Liquidity ratio indicates whether management is able to pay debts as they fall due. a ratio of 1 or more may be considered safe depending on the type of business. The two ratios that are used to analyse the financial statement is the current asset and the acid test ratio. They are not debt ratios in the true sense but provides a good indication of whether the company will have problems servicing its debts better than interest cover does in the sense that operating profit does not represent net cash collected during the period. Current ratio The current ratio is calculated by dividing current assets by current liabilities. It tells whether the short term creditors are covered by assets that can be converted quickly. The ratio has improved from 60% in 2009 to 80% in 2010 but it is still not good. Current assets used in calculating current ratio include inventories which takes a longer period to become cash than other current assets. For this reason a better indicator of the company’s ability to pay debts as they fall due is the acid test ratio which is discussed below. Acid Test Ratio The acid test ratio is a better indicator of whether the company will be able to pay its debts as they fall due. The acid test ratio does not include inventory because it may take some time to be disposed of and is not considered as liquid as the others current assets. The ratio is very low at 37% in 2009 and 47% in 2010. This is a major improvement but is still not sufficient. This ratio needs to be at least 1 if the company needs to be viewed in a good light. The low ratios suggest that the company will not be able to pay its debts as they fall due. Marks and Spencer will need to work on improving them. The following cart provides a better picture of the situation. The chart shows the amount of interest bearing debts in the capital structure compared to equity. There are other debts and so it represents a worrying situation. Cost of capital The cost of capital is found by applying the relative weights to the interest on debt and equity in order to find the overall cost of debt. The company has a mixture of debt and equity and the interest rates are different. A weighted average is therefore calculated to determine this average. The table below shows the cost of capital for the year ended April3, 2010 and 2009 with supporting information in the Appendix. It shows that the WACC has increased for 5.8% to 6.28% which is not very good for the company. Beta was required to calculate the cost of equity. This information was obtained from Reuters.com. See information in the reference. The ten year bond rate was used as the risk free rate and the market rate was obtained from Scribd.com Marks and Spencer Weighted Average Cost of Capital (WACC) 2010 Description Formula Results Cost of Debt rd(1-T) 4.55% Cost of Equity rs= rRF + (RPM)bi 7.65% WACC 0.56 x rd(1-T) + 0.44*rs 6.28% rRF 0.0325 RPM rm - rRF 5% bi 0.88 Debt 2832.8 Equity 2185.9 Total Capital 5018.7 Percentage Debt (Wd) 2832.8/5018.7 0.56 Percentage Equity (We) 2185.9/5018.7 0.44 Marks and Spencer Weighted Average Cost of Capital (WACC) 2009 Description Formula Results Cost of Debt rd(1-T) 4.56% Cost of Equity rs= rRF + (RPM)bi 7.65% WACC 0.60 x rd(1-T) + 0.40*rs 5.80% rRF 0.0325 RPM rm - rRF 5% bi 0.88 Debt 3200.6 Equity 2100.6 Total Capital 5301.2 Percentage Debt (Wd) 3200.6/5301.2 0.60 Percentage Equity (We) 2100.6/5301.2 0.40 Notes rRF Risk free rate RPM Market Risk Premium bi M&S beta rm Market return The figures reveal that the company’s WACC of 6.28%. If the company’s debt ratio does not improve it may have to pay a higher interest rate in order to access further loans. Conclusion The company needs to work on improving it capital structure to ensure its survival. It runs the risk of not being able to pay its debts on time. If that happens then there will be fees and additional penalties which will further exacerbate the situation. The company’s cost of equity is rather high and the wrong signal should not be sent. The company may consider not paying dividends in order to reduce its debts since M&M theory indicates that the shareholders will be able to manufacture their own dividends. However, the company has a variety of shareholders, some of which depend on their dividends as a source of regular income. This will send the wrong signal resulting in lower stock prices. Reference BPP Learning Media Ltd. (2009) ACCA Paper F7-Financial Reporting. London, UK: BPP Learning Media Ltd. Brigham, E.F. and Ehrhardt, M.C. (2005) Financial Management: Theory and Practice. 11th ed. USA: Thomson South Western Fernandez, P and del Campo, J. (2010) Market Risk Premium used in 2010 by Analysts and Companies: a survey with 2,400 answers. Retrieved from: http://www.scribd.com/doc/32121177/Market-Risk-Premium-Used-in-2010-by-Analysts-and-Companies. Last accessed 6th Jun 2011 Marks and Spencer (2010) Financial Statements 2010. Retrieved from: http://annualreport.marksandspencer.com/downloads.aspx. Last accessed June 6 2011 Reuters. (2011). Marks and Spencer Group PLC. Retrieved from: http://www.reuters.com/finance/stocks/overview?symbol=MKS.L. Last accessed 6th Jun 2011 Appendix Calculation of the Cost of Debt Supporting Calculations 2010 Rate (rd) Debt (?m) Weight (W) rd x W 6.38% 314.6 14.41% 0.92% 5.88% 279.9 12.82% 0.75% 5.63% 399.5 18.29% 1.03% 6.25% 333.8 15.28% 0.96% 6.13% 403.5 18.48% 1.13% 7.13% 199.6 9.14% 0.65% 6.88% 253 11.58% 0.80%         Total Debt 2183.9 Average Rate 6.23% Supporting Calculations 2009 Rate (rd) Debt (?m) Weight (W) rd x W 6.38% 382.6 18.95% 1.21% 5.88% 417.9 20.69% 1.22% 5.63% 399 19.76% 1.11% 6.25% 354.4 17.55% 1.10% 6.13% 0 0.00% 0.00% 7.13% 212.9 10.54% 0.75% 6.88% 252.6 12.51% 0.86%         Total Debt 2019.4 Average Rate 6.24% Read More